Executive Bonus Plan

The executive bonus plans work as follows:

• The company provides the key executive with a bonus that is treated as taxable as income to the recipient. The bonus is generally a tax-deductible business expense for the company.
• The bonus is used to purchase a whole life or universal life insurance policy that builds cash value that grows tax deferred. Access to the cash surrender value is usually restricted by the company until a specific future date.
• The life insurance policy, if properly structured, may provide an attractive benefit to the executive in the form of cash value growth. Any cash value accumulation will grow tax deferred and may be accessed by the employee income tax-free through withdrawals and policy loans. The policy’s cash value can be used to supplement retirement income or for any other financial need.
• If the key executive dies, in most cases, the heirs will receive the death benefit proceeds from the life insurance policy income tax-free.

Variations of Executive Bonus Plans

In addition to the basic Section 162 executive bonus plan, there are other common plan variations. Executive bonus plan examples include a double bonus arrangement and a restricted or controlled executive bonus plan.

With a double bonus arrangement, the company will provide the key executive with a bonus large enough to pay the life insurance premiums as well as the income taxes incurred by the key executive on the bonus. The company can use the double bonus arrangement to eliminate any out-of-pocket expense for the key executive.

If the company wishes to retain some measure of control over the bonus, the controlled executive bonus design is a desirable choice. With a controlled executive bonus, the company and the key executive enter into an agreement. That includes a vesting schedule on the policy’s cash value growth.

The vesting schedule is a form of “Golden Handcuffs” that allows a company to limit the availability of the cash value benefits until the executive has fulfilled the terms of the agreement. At that time, the executive is “vested.” Once the key executive is vested, they gain full and complete access to the policy’s cash value.

Advantages of Executive Bonus Plans

Executive bonus designs using life insurance have several advantages, including:

• An executive bonus plan is simple to implement and easy to administer.
• The business can selectively choose the key employees they wish to reward.
• The bonus payments may be considered a fully deductible expense to the company.
• The key employee can name the beneficiary of the entire death benefit of the life insurance policy.
• In many cases, unless there is a “restricted or controlled executive bonus,” the key executive will have immediate access to policy cash value and may access that cash value without income tax through policy loans and withdrawals.
• Executive bonus plans are not subject to “qualified plan limits.”

Disadvantages of Executive Bonus Plans

There are also some inherent disadvantages to using executive bonus plans, including:

• The company is unable to fully recover its costs from the policy’s death benefit, since the key executive names the policy beneficiary.
• Executive bonus plans offer the company very little control of the policy. Even if a controlled executive bonus is utilized, it only restricts the key employee’s access to the policy’s cash value. The bonus is never recovered by the company even if the key employee leaves the company prior to vesting.
• The key executive must include any bonus in his or her taxable income.
• Without additional planning, the life insurance policy’s death benefit will be includable in the key executive’s taxable estate

To read more about different types of life insurance, the Minnesota Department of Commerce website may be a good resource.

Interested in implementing an executive bonus plan in your organization? Request more information!